The Australian Prudential Regulation Authority (APRA), the Australian Securities
and Investments Commission (ASIC) and the Reserve Bank of Australia (RBA) (together,
the regulators) have been considering for some time the desirability of reforms
to the functioning of domestic over-the-counter (OTC) derivatives markets.
The regulators' ongoing interest in these markets reflects their various
mandates regarding market and participant supervision, as well as broader financial
stability and prudential considerations. This interest encompasses the structure
and functioning of markets, the infrastructure that supports these markets,
and the nature and behaviour of participants.

A key question for the regulators has been whether there is a need for direct regulatory
intervention to drive additional reforms in the Australian market. The regulators
have a number of existing regulatory tools available, mainly with respect to
conduct and prudential requirements applying to licensed market participants.
Additionally, the Australian Government has introduced into Parliament the
Corporations Legislation Amendment (Derivative Transactions) Bill 2012 (Derivative
Transactions Bill). This Bill proposes amendments to the Corporations Act 2001 to create additional regulatory tools to
implement reforms in OTC derivatives markets. In particular, mandatory trade
reporting, central clearing or trade execution obligations could be imposed
for specified classes of products and participants. The Bill requires that
the regulators be consulted when any such obligations are proposed or implemented.

The regulators recognise that the efficiency, integrity and stability of domestic
OTC derivatives markets can be enhanced through the use of centralised infrastructure
such as trade repositories, central counterparties (CCPs) and trading platforms.
In promoting a transition to such an environment, the regulators also recognise
the importance of retaining the benefits of OTC derivatives markets wherever
possible. Accordingly, the regulators would therefore seek to promote the adoption
of centralised infrastructure in a flexible manner to permit an industry-led
transition as appropriate. The regulators also recognise that not all products
and participants are amenable to a transition to centralised infrastructure;
in such cases, however, it is important to ensure other risk management measures
are rigorously applied.

The regulators will also take into account whether imposing mandatory central clearing,
trade reporting or trade execution requirements would support the recognition
of Australia's regulatory regime as comparable or equivalent to those of
key overseas jurisdictions. This would enable Australian participants and financial
market infrastructure to avoid a duplicated regulatory burden, with Australian
entities being primarily regulated in Australia where sufficient equivalence
or substituted compliance tests are met.

The Australian regulators have consulted widely in recent years to understand better
how the benefits of centralised market infrastructure might be realised in
the Australian OTC derivatives market. To provide an additional empirical basis
for further exploring these issues, in July 2012 the regulators undertook a
voluntary survey of more active market participants, covering large domestic
and international banking groups, smaller authorised deposit-taking institutions
(ADIs), fund managers, government borrowing authorities, corporate treasuries
and electricity companies.

Based on an assessment of the state of play in the domestic OTC derivatives market,
the regulators make the following recommendations around infrastructure usage
and risk management:

Trade reporting

In the view of the regulators, having as many OTC derivatives transactions as possible
reported to trade repositories would enhance the efficiency, integrity and
stability of the Australian financial system.

The regulators recommend that the government consider a broad-based mandatory trade reporting
obligation for OTC derivatives should the Derivative Transactions Bill be passed.

The parameters of a trade reporting mandate, including the specific products and
participants subject to the mandate and the data reported, could be addressed
in regulations or rules. Trade reporting requirements could be introduced under
appropriate phasing arrangements, taking into account the relative importance
of particular instrument classes and categories of reporting entity, as well
as the availability of licensed trade repositories.

Central clearing

The regulators are of the view that central clearing of the Australian dollar-denominated
interest rate derivatives market would bring substantial benefits to the efficiency,
integrity and stability of the Australian financial system. This benefit would
be most immediately realised if larger market participants, such as the large
Australian-based banks, were to participate in central clearing.

The available evidence suggests that a migration of these participants towards central
clearing is underway; larger foreign financial institutions are already (or
will soon be) participating in central clearing for these instruments. Once
a licensed CCP that clears these products is available in Australia, the regulators
would expect that a transition to central clearing should accelerate.

Given this, at this stage additional regulatory intervention does not appear warranted
in order to achieve a substantial uptake of central clearing in this market.

The regulators recommend that a mandatory clearing obligation for Australian dollar-denominated
interest rate derivatives is not necessary at this time. However, should substantial industry progress
towards central clearing in this class of derivatives not be evident in the near future, the regulators
would revisit this recommendation.

There could also be some merit in exploring mandatory obligations further if it was
considered that having these in place was a net benefit to Australia, such
as by reducing the cost of Australian- or foreign-based market participants
engaging in cross-border transactions, or by providing greater certainty to
participants as to how they may satisfy their regulatory obligations. Additionally,
the regulators would be concerned if, by adopting a flexible approach, opportunities
for regulatory arbitrage emerged between the Australian regime and those in
effect in other jurisdictions.

The regulators will continue to assess market developments, with a view to considering
where central clearing for other products might be warranted. While there are
strong in-principle benefits from central clearing in product classes such
as cross-currency swaps, foreign exchange (FX) and credit derivatives, at present
no viable central clearing solution exists for these.

Risk management for non-centrally cleared trades

In reviewing market participants' risk management practices, a number of issues
were identified where further attention from participants or regulators would
seem warranted. In particular:

Participants should ensure that adequate credit support arrangements are in place for all
OTC derivatives transactions.

The regulators consider that for large and more active market participants, daily collateralisation of
exposures should be adopted as best practice in the market where possible. It is recognised that this
needs to be balanced against the operational costs and liquidity risks that this may create for some
types of counterparties.

Market participants should understand the increased counterparty exposure generated by posting
collateral over and above mark-to-market (variation margin) requirements, and ensure that the
resultant risks are adequately managed.

The regulators see increased benefits in there being a more coordinated market-wide approach to
the usage of trade compression services. The regulators call on the industry to consider how this may
be achieved.

Although there has been some increase in the use of portfolio reconciliation services, the regulators
consider that a greater utilisation of these services should be pursued by the industry.

In addition to industry-led changes to the use of credit support for non-centrally
cleared transactions, international standard setters are considering principles
for margin requirements applicable to such transactions. The regulators will
continue to monitor these developments and provide advice to the government
as appropriate.

The results of the survey also indicate shortcomings in the counterparty credit risk
management practices of some participants in the OTC electricity derivatives
market, relative to other OTC derivatives markets. The regulators consider
that further work should be undertaken to explore these issues.

Trade execution

The regulators see in-principle benefits in a greater utilisation of trading platforms
in the Australian OTC derivatives market. However, further analysis is required
to identify where or how these benefits might be best realised, and therefore
at this stage the regulators do not propose to make any specific recommendations
as to possible trade execution obligations.

The remainder of the report is structured as follows:

Chapter 2
provides more context to the policy concerns around OTC derivatives markets, discusses
regulatory responses and the merits of centralised infrastructure in these
markets, and relevant aspects of the Australian regulatory framework

Chapter 3
discusses domestic and international regulatory developments regarding OTC derivatives
markets, and industry work that is complementing these

Chapter
4 sets out key characteristics
of the Australian OTC derivatives market, using information collected through
the regulators' survey as well as a variety of other data sources

Chapter 5
discusses developments in risk management practices in the Australian
market, including participants' use of financial market infrastructure

Chapter 6
discusses more fully the regulators' recommendations around centralised
infrastructure and risk management, drawing on the discussions in earlier
chapters